Question

Said Al Hamli and his friend Khaled Al Masri are the owners of a small hotel, the Sun Star, in the Red Sea town of Hurghada. Close to Cairo, the resort town has grown from a fishing village to one of Egypt’s famous vacation spots. Hurghada is the gateway to many small islands and offshore reefs favored by recreational snorkelers and divers and many tourists combine their stay with excursions to the Nile Valley, the Great Pyramids and Luxor.

To take advantage of the growing numbers of tourists, particularly from Europe and the Middle East, Said and Khaled are planning to double the room capacity of their hotel by adding a second building to the already existing structure. Fortunately, Said recognized the great potential of Hurghada ten years ago, well before the town became a hub for recreational tourism, and bought the land adjacent to the hotel for relatively little money when it was still under construction.

Now, Said and Khaled are studying the new layout and trying to determine if the expected revenues justify the substantial initial investment of EGP 70 million ($11.8 million). According to their calculations, operating cost would rise by EGP 23.8 million ($4 million) in the first year, which would include hiring and training of new personnel, maintenance of facilities and equipment etc., and likely increase by about 5 percent per year thereafter. With an aggressive marketing strategy, Said and Khaled believe that a revenue enhancement of EGP 20.8 million in the first year is realistic and that a subsequent annual increase of about 15 percent for eight to nine years, with revenues leveling off thereafter, can be achieved. Ideally, Khaled would like to retire in ten years. Seeking advice from you, a knowledgeable friend, they share their detailed cost and revenue projections with you.

Year	Cash (EGP)	Revenue (EGP)
0	−70,000,000
1	−23,800,000	20,825,000
2	−24,990,000	23,949,000
3	−26,239,000	27,541,000
4	−27,551,000	31,672,000
5	−28,929,000	36,423,000
6	−30,375,000	41,887,000
7	−31,894,000	48,169,000
8	−33,489,000	55,395,000
9	−35,163,000	63,704,000
10	−36,922,000	73,259,000

No cost of capital given

QUESTIONS

1.

Determine the resulting net cash flow for each year;

and compute:

a.	the net present value,
b.	the simple payback period,
c.	and the profitability index.

2.

Give your decision on each result in terms of the project’s expected profitability and Khaled’s ten-year investment horizon

Answer 1

	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5	Year 6	Year 7	Year 8	Year 9	Year 10
Net cash Flow( in mn)	-70	-2.975	-1.041	1.302	4.121	7.494	11.512	16.275	21.906	28.541	36.337

The IRR of the project is 7.0775 %

Assuming a rate of return of 6 %

NPV = EGP 6 mn

Hence payback period = 8 years 5 months

Profitability index = 1.085

We see that the NPV is positive at 6%. Hence the project can be accepted. Also, the project has a payback period quite high. The profitability index is also quite close to 1. Other factors constant since the cost of capital is greater than the rate at which my costs are increasing every year, and with a positive NPV, we can accept the project.